Money illusion and “real backwardation” in oil

There are three possible explanations for this strange state of affairs:

(a) The market expects oil prices to fall in real terms over the next five years (because supply remains ample or demand is expected to fall as conservation and substitution bite into consumption). In this scenario, peak oil is a myth. Prices will actually drift lower (in real terms) as previous shortages dissipate.

(b) The market is assuming inflation will remain low (less than 1.75 percent over the next half-decade). The economy might even suffer deflation. Sluggish growth and surplus capacity will ensure prices rise slowly, even decline. In a low-growth, deflationary environment, demand for oil, and oil prices, are unlikely to rise much.

(c) The market is mis-valuing far forward contracts, marking them too low to fully reflect the compounded effect of rising prices over five years.

Neither explanation (a) (falling real oil prices) nor (b) (general deflation) seems consistent with expectations of a gradual global recovery and medium-term tightening of the oil market as demand picks up and new sources of supply prove difficult and costly to bring onstream. So explanation (c) (futures contracts are undervaluing expected future oil prices) is the most plausible.

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